NovaStar, peers differ on accounting

Also, updates on Zix, Joseph Bank

By

HerbGreenberg

Updated to clarify the status of NovaStar's REIT filing.

SAN DIEGO (CBS.MW) - Thursday thwack:

NovaStar -- the plot thickens: Not another piece about NovaStar! Yes, sorry to say, I can't resist because the story just keeps getting better. And with a daily column it's easier to follow the twists and turns in saga-like style. (Reader revolt over so many items on one company reminds me of the time my colleagues at the San Francisco Chronicle started the chant, "No more Iomega!" after yet another item on the company in its stock-market heyday. Or reader reaction to more than 90 items on the now-defunct Lernout & Hauspie and other stories, as well, but I digress...)

This time I direct your attention to NovaStar's heavy reliance on the non-cash gains from selling mortgages. This is where it sells off packages of loans to other investors and then immediately books a lump-sum non-cash gain on the sale of those loans based on the amount of cash it believes it will receive over time. The amount sold off is discretionary, and the amount of cash expected (and booked) is based on assumptions made by management. These assumptions, which are continuously revised, can have a critical impact on taxable income as well as future dividends.

To say gain-on-sale accounting is controversial, especially for a REIT like NovaStar -- last year the country's 10th largest seller of mortgage-backed securities -- would be an understatement.

And while booking non-cash gains on the sale of loans isn't a new issue, there's a new twist: It's considered so dicey for dividend reliant REITs that the newest applicants to become mortgage REITs have decided to just say no. Sub-prime lenders New Century Financial
NCEN, +0.00%
and Saxon Capital
SAXN
which recently announced plans to convert into REITs, have decided for tax purposes to account for the sale of loans differently than NovaStar
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Instead of booking the gains up front, they're treating the sales as financings, which will result in booking income as it's received. Noting that their public REIT filing hasn't yet been approved by the SEC, both companies declined to elaborate.

Their decision isn't entirely surprising to industry watchers and insiders. Use of gain-on-sale accounting by mortgage REITs is "perceived as a big negative from the street," says analyst Mark Agah of Portales Partners in New York. The reason, he says, goes back to the late 1990s, when sub-prime lenders were relying heavily on non-cash gains from sale of mortgages. Then, almost overnight, thanks in a number of back-to-back debacles -- including the demise of Long-Term Capital and the Russian debt crisis -- the mortgage-backed securities market went into a tailspin. "The market for sub-prime mortgages essentially dried up," Agah says.

With the secondary loan market virtually shut down, the companies suddenly couldn't sell off loans and book more big gains. Before long there were loans to repay and they rode a monster wave of write-offs. Needless to say, dividends were deferred or eliminated; it was a mess.

With the notable exception of NovaStar, whose dividend was also interrupted, survivors among mortgage REITS weaned themselves off a heavy reliance on gain-on-sale accounting. While they're giving up big up-front gains, "they're probably putting themselves in a position to pay dividends more consistently in the future," Agah says. That's because unlike NovaStar, they're less reliant on quarterly loan originations and more on loans already on their balance sheet.

Loan originations are critical for NovaStar because the more loans originated by itself and by others, whose loans it may buy, the more loans it can sell. If all goes right, gains from those sales will translate into higher taxable income and dividends. NovaStar explains its reliance on loan sales in a "fact sheet" attached to last quarter's earnings release. But the reverse is also true, and the impact of fewer loan sales could be devastating. That's why a veteran executive of another mortgage REIT that no longer does much in the way of gain-on-sale accounting -- who didn't want his name used -- says, "At the end of the day we feel we'll be rewarded by shareholders by creating long-term income regardless of whether the mortgage business is hot." He says his investors "are looking for stability of dividends, and 75 percent to 80 percent of our current earnings are coming from" existing loans on the balance sheet."

He adds, "If we are able to generate a 10 percent to 12 percent rate of return, we may be a boring stock, but shareholders will love us. That's our strategy -- to be boring. At the end of the day shareholders want their dividend."

Boring is definitely not how you would describe NovaStar, which sticks out like a sore thumb on the investment-metrics scale. Nothing underscores the difference than NovaStar's dividend, which is a jaw-dropping 41 percent of its book value compared to the mid-teens for most other mortgage REITs. If nothing else, says one short-seller, it shows just how much the company is "obviously recognizing income differently than its peers...unless of course, NovaStar has the secret sauce."

So, why does NovaStar structure its sale of loans the way it does when other mortgage REITs have chosen to do it another way? Why doesn't it change to the structure used by the other companies? Has it considered structuring future loan sales the way other companies do it? I asked the company all three questions. "This is a strategic decision that we don't discuss," an attorney for the company said. "We don't know and we don't speculate on the strategies of our competitors."

Moving on....

Zix for zax: Have been so jammed I forgot to mention that a week ago Jackson Spears of Show-Me Research initiated coverage on Zix Corp.
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with a "strong buy." And a 12-month price target of $20. The big story around Zix, as this column has pointed out previously, is its role as a leading technology provider in the emerging e-prescription market. Spears says he doesn't expect the company to reach profitability or show positive cash flow until the third quarter of its next fiscal year. As a result, he says, for valuation purposes he has relied on the potential market for e-healthcare. Spears also says the company could be an acquisition target. In the end, he expects the company to snare 30 percent of the market, which in the minimum could translate into annual revenues of $300 million with pre-tax income of $150 million.

Banking on Bank: The most intriguing part of the story about New York Attorney General Eliot Spitzer subpoenaing documents on April 22 from Jos. A. Bank
JOSB
regarding its advertising isn't the request itself. It's that rather than disclose the news when it announced earnings on May 25, Bank waited until yesterday -- the day it announced a stock split -- to also file its 10-Q, in which the news was disclosed.

In the latest edition of Herb Greenberg's RealityCheck, Herb looks at whether Interstate Bakeries can stand the heat. He also mentions potential trouble for Archer-Daniels-Midland.

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